The Financial Meltdown Continues
Virtually the only certainty in the current financial situation is that there will be more problems ahead. Those who controlled the levers of economic and financial policy neglected their greatest responsibility, which was to ensure an orderly financial market and prevent exactly the sort of collapse that we are now seeing. This was a policy failure of massive proportions, not a natural disaster.
The central problem remains the collapsing housing market. The Case-Shiller 20-City Index shows a nominal price decline of almost 20 percent over the last two years, an event that few in the financial sector apparently considered to be a serious possibility. This price decline has led to an unprecedented rate of defaults on mortgages and derivative instruments.
These defaults, in turn, have raised questions about the solvency of a large number of financial institutions. This has led to an increase in the price of risk more generally and the crisis of confidence that is currently shaking financial markets world-wide.
While there is no simple path out of this crisis, it was a crisis that could have been easily avoided. If the Federal Reserve Board had acted to stem the growth of the housing bubble before it grew to such dangerous proportions, the country would not currently be facing a recession and the prospect of a financial collapse.
Alan Greenspan had the tools necessary to rein in the bubble had he been so inclined. First, he could have imposed tighter restrictions on mortgages, as the Fed has recently done. This would have prevented many of the worst mortgages that led to the subprime crisis and helped inflate housing prices.
More importantly, he could have used his platform as Fed chairman to explicitly warn of the dangers of the housing bubble. In his congressional testimonies and other public appearances, he could have carefully explained how house prices had diverged from a 100-year long trend in the mid-90s.
He could have pointed out that after just increasing at the same pace as overall inflation for a century, house prices suddenly jumped by more than 70 percent, after adjusting for inflation, in the decade from 1996 to 2006. He could have shown that this increase was not supported by any changes in the fundamentals of supply and demand in the housing market, nor was it matched by any remotely comparable increase in rents.
If Chairman Greenspan had pointedly made the case for the existence of a housing bubble and explicitly warned of the losses likely to be suffered by individual homeowners and the huge risks being taken by financial institutions that were heavily invested in mortgages and mortgage derivatives, it almost certainly would have been sufficient to take the air out of the bubble. As a last recourse, he could have raised rates with the explicit purpose of bringing down house prices.
Instead, Greenspan repeatedly denied the existence of a housing bubble, dismissing the warnings of the small group of economists who tried to call attention to the potential dangers posed by a housing bubble. Greenspan's denials helped create a false confidence that allowed the bubble to continue to expand. It also helped to fuel the complacency in financial markets that led the country's largest financial institutions to ignore potential risks and to become very highly leveraged against their capital.
There are no easy solutions to a financial crisis of the sort the economy currently faces. It is not possible to change history and we must work with the crisis that the collapse of the bubble has created. However, it is important to recognize that this crisis was entirely foreseeable and preventable.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.
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Asymmetrical Risk Assessment
By Casten, J.D. at Sep 20, 2008 23:59 PM
I’m not a rocket scientist economist, but from what I understand, Dean Baker’s placing much of the blame on the Federal Reserve is apt.
The Fed can basically heat up the economy by lowering its rates, which increase the monetary supply; or decrease its rates and stem inflation (I like to think of how inflation has exploded when governments have simply printed more money, making each “dollar” worth less—and how burning such cash would make each scarce paper dollar worth more).
Baker points out that beyond “jawboning” from the pulpit, Greenspan could have raised rates to bring down housing prices (deflation). But I think the corollary to that is that by keeping the rates so low for so long, the Fed pumped up the economy to create at least two bubbles in a row… the internet bubble, and then the housing bubble—basically creating an environment where money could be borrowed on the cheap, and invested in or lent to (a) internet start-ups; and then (b) mortgages. Of course, with the internet bubble, many companies proved not to have the “fundamentals” of a sound business (the bubble burst); and with the sub-prime mortgage crisis, people were lent more money than they could pay back (especially with unscrupulous banks making loans where the required payments could balloon in the future). Possibly the rush of bankruptcies that occurred when congress passed legislation to tighten regulations on such for consumers exacerbated this credit problem.
The problem faced now, as I see it (beyond the failing financial institutions)—is: how can the Fed heat up the lending economy so that sound consumers and businesses can get credit, especially small businesses that provide an engine of employment growth and need loans to expand—how can the Fed promote this agent of economic growth when (a) it’s rates are already so low, (b) there’s a capital vacuum – less money for banks to lend, as investors shy away from the volatile market and all those bad loans are written off, and (c) lowering its rates is what may have caused the bubble in the first place.
As far as solutions are concerned, I understand the government may be getting a square deal with all the assets its buying at bargain basement prices… it just has to hold on to these until they are worth more (which may take years).
And at a minimum, the risk assessment of certain financial products must be made transparent—there may have been some conflicts of interest between credit rating firms (think of A, B & Junk Bond ratings, etc.)—and the investment banks, who pay them for their ratings, and who in some cases may have been lying about soundness of their investments. I don’t buy into the story that such calculated risk is too complex to understand… and that credit rating firms must go on the word of some firm’s computer programmer quants. True, many different types of risk may have been bundled together… but a hallmark of “the smarts”—if these “quants” truly are smart—is the ability to simplify complexities and make them understandable to lay people. No… I think people wanted to bury high risk in order to get better credit ratings, borrow more, and invest in more high risk investments (e.g. sub-prime mortgages).
I’d think the Fed should hold off on any drastic rate changes (they’re already so low)… and wait to see the effect of what should be immediate implementation of various financial regulations (and insurance funds like the FDIC for financial institutions). What may be needed are “barriers,” “buffers,” and “transparency”—regulatory barriers against certain types of financial transaction, insurance buffers to catch “emergency fluctuations” in markets, and the transparency to provide more symmetrical risk assessment.
Meanwhile the bailout of these financial institutions looks bad… to both free-market folks, and those concerned with corporate welfare. But I don’t see an oncoming train at the end of the tunnel… maybe because I’m not an economist (thinking like the little train that could)… or, maybe because I see the ever more interconnected financial world as robust enough to handle financing problems through the brute force of economic infrastructure, wizening financial policy, and the possibility of confidence based on level-headedness, not lies.Reply this comment